“The crucial thing is to understand what banks do. And it’s not mostly about money creation! Instead, what banks are for is helping to improve the tradeoff between returns and liquidity.

Actually, what banks do is mostly about money creation. Of a sort. See here, here, and here. But I digress.

“Like a lot of people, my insights draw heavily on Diamond-Dybvig (pdf), one of those papers that just opens your mind to a wider reality. What DD argue is that there is a tension between the needs of individual savers — who want ready access to their funds in case a sudden need arises — and the requirements of productive investment, which requires sustained commitment of resources.

Banks can largely resolve this tension, by offering deposits that can be withdrawn on demand, yet investing most of the funds thus raised in long-term, illiquid projects. (…)

The problem, of course, is the vulnerability of such a system to self-fulfilling panics: if people believe that a bank will fail, everyone will in fact want to withdraw funds at the same time — and because the bank’s assets are illiquid, trying to meet those demands through fire sales can in fact cause the bank to fail.

This then leads to the need for policy: deposit insurance and/or lender of last resort facilities to head off bank runs, and bank regulation to reduce the moral hazard from these explicit or implicit guarantees.

So, according to Professor Krugman’s defense of Bagehot banking, the alleged purpose of banks is to resolve this “tension” between the need of individuals for ready access to their funds, and the “sustained commitment of resources” required for “productive investment”. The banking system — designed in the 17th century — can “largely” resolve this tension, but is vulnerable to bank runs, and so requires complex regulation, and deposit insurance and/or central banks to support it.

Here is an alternative solution to the Diamond-Dybvig-Krugman “tension” problem.

By giving everyone a tool to create ‘money’ in the same way that banks do — by simple double-entry bookkeeping — individuals can always have ready access to funds, and make sustained commitments to productive investments. No vulnerability to bank runs. No need for complex regulation, deposit insurance, or a “lender of last resort”.

“Tension” problem solved.

This is, after all, the 21st century Paul. Things have moved on a bit.